Financial Innovation, Firm Size and Growth

Abstract

Small …rm lending has historically been very costly because of the paucity of information. We study the disproportionate impact of …nancial development (measured as the current level of a …nancial system) and …nancial innovation (measured as its change) on small …rm sectors. We incorporate …nancial innovation and …nancial development into a Schumpeterian endogenous growth model. Entrepreneurial skill on a continuum of types is private information; thereby creating adverse selection problems. In the absence of …nancial innovation, an arrival of new technology frontier renders existing screening technology obsolete; thereby having largely negative impacts on small …rm sectors. Our model suggests that …nancial innovation is more pronounced in small-…rm sectors in more …nancially developed countries. The linkage between …nancial innovation and the disproportionate impact on small …rm-sectors is weak in less …nancially developed countries. At the European industry level, empirical evidence is more consistent with our model prediction